Lower Equity Returns

There is a solid analytical basis for the broadening consensus that equity investment returns have fallen permanently.

For many years, strategists have been arguing that investors should expect lower equity returns. This likelihood originally hinged on weaker population growth but market valuations have also affected judgments about prospective returns. For example, Shiller and Campbell have shown that above average stock returns occur after the ratio of price to average earnings over the previous 10 years has been unusually low.

Investors and their advisers fought hard to prevent the foreshadowed slowdown. They did their best to conjure up some highly imaginative and, ultimately, misleadingly attractive new products to sustain impossibly high returns. However, the events of 2008 precipitated a new reality.

Equity investment returns will be driven by growth in earnings which will reflect four key ingredients.

1. Per capita GDP growthAdding capital might increase output per person but is likely to do so at a declining rate. If investment occurs up to the point at which the marginal product of capital is equal to its cost, the capital/labour ratio will stabilize. New technology might offer the chance of using less labour for any given level of output but per capita GDP growth will cease if technological innovation is no longer a driver.

Since technology is generally sought out and used competitively, per capita growth rates should converge among countries at a similar stage of development.

Bradford Cornell in the February 2010 issue of the Financial Analysts Journal shows that between 1923 and 2006, the average per capita growth rate across 15 mature economies was 2.19% per annum. Eight of the 15 had growth rates between 1.9% and 2.3%. The lowest growth rate was in the USA (1.42% per annum). The highest was in Japan (3.11% per annum).

2. Population growthPopulation growth changes only slowly. Among the advanced economies, growth rates have already declined and, even in the more strongly growing centres such as Australia and the USA, they are set to add no more than 1% to real economic growth.

3. Profit shareFor profits to grow faster than GDP, the share of profits in total income must be rising. However, there has been a historical tendency for the share of profits to be stationary. The share can be volatile but, in both the USA and Australia, the profit share has tended back to its longer term value even after large departures from the norm.

While the current Australian profit share is higher than average, it remains around levels reached in the 1960s, 1970s, 1980s and 1990s. As the recent Australian experience with the resources sector super profits tax showed, there will be a variety of institutional barriers preventing an indefinite rise in the profit share.

4. Earnings dilutionSome portion of new profits will be attributable to new shareholders. Existing investors will suffer dilution. They will not participate in the earnings of new businesses unless they dilute their holdings in existing businesses.

Within these constraints, real GDP growth could be limited to around 3%. Since the share of profits in total income has already risen to the upper end of its historical range, the likelihood of profit growth outstripping GDP growth will have been reduced.

Share issues and repurchases will have an effect on the full extent of earnings dilution but even assuming a neutral outcome suggests a real rate of earnings growth well below 5% a year.

Average annual growth rates could exceed compound annual growth rates because of the year to year volatility that occurs. This might add 0.5-1.0% to average annual earnings growth, in practice. This might take investment returns just above 5%.

This framework suggests some difficulty in achieving earnings outcomes in line with pre 2008 growth rates. Nominal growth rates approaching 10% or market returns of 15-20% which had become commonplace in the 1990s and early 2000s should not be anticipated.

How investors make the mental transition to this lower rate of growth will be an important challenge for markets. In July, the Australian market rose by 4.5% and the S&P 500 was up 6.9%. They were regarded as good outcomes leading to questions about whether similar returns could be achieved in subsequent months.

In this new, lower growth environment, returns of this magnitude in one month could account for most if not all the growth in an average year. Far from being a basis for optimism, a 4-6% outcome in one month could simply flag the possibility of at least several months of negligible or negative returns for an average year.

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